week 2 | financial analysis Flashcards
describe ROE & formula
(return on equity) Most common analysis metric used by managers & investors alike
ROE = Net Income/ Average shareholders’ equity
- Measures return from perspective of company’s stockholders
what does ROE do for parent company
ROE measures return to the controlling (parent company) stockholders
what is noncontrolling interests
- part of a company (subsidiary) that parent company doesn’t fully own
- reps ownership held by outside investors or minority shareholders in that company
- Need to consolidate statements (with subsidiaries)
ROE formula under noncontrolling interests
ROE = (net income attributable to the parent company’s stockholders) / (equity attributable to the parent company’s stockholders)
what does ROE do for common stockholder
ROE measures return to the common stockholders
what formula does preferred stock necessitate
ROCE = (net income - preferred dividends) / (average stockholders’ equity - average preferred equity)
why is analysis done on ROE
Performance analysis seeks to uncover the drivers of ROE & how those drivers have trended over time to better predict future performance
2 methods to measure ROE drivers:
1.Traditional DuPont analysis that disaggregates ROE into components of profitability, productivity, & leverage
2. ROE analysis w/ an operating focus that distinguishes b/w operating & non-operating activities
- Operating activities drive shareholder value
dupont disaggregation of ROE (formula)
ROE = (net income)/(avg. stockholders’ equity) = (net income/avg total assets) [ROA] x (avg total assets/avg stockholders’ equity) [FL]
dupont disaggregation of ROE (explanation)
- ROE reflects both
- Company performance (as measured by ROA)
- How assets are financed (as measured Financial Leverage)
- ROE is higher when there is more debt & less equity for a given level of assets
- Tradeoff → greater debt means higher risk for the company
ROA formula
ROA = net income / average total assets
what is ROA
- ROA measures return from the perspective of the entire company (enterprise level)
- Includes both profitability (numerator) & total company assets (denominator)
- ROA analysis encourages managers to focus on both the IS & BS
how to get high ROA
To earn a high ROA, the company must be profitable & manage assets (hold the lowest level of assets possible to achieve the desired profit)
financial leverage formula
FL = average total assets / average stockholders’ equity
what is financial leverage
- FL measures the relative use of debt vs equity to finance the company’s assets
- Important → debt is a contractual obligation & a company’s failure to repay principal or interest can result in legal repercussions or even bankruptcy
- Decision as CFO
- Double your money in the return (leverage)
- Better if return is above 10
what does Higher financial leverage mean
- Higher debt & interest payments
- All else equal, increases the probability of default & possible bankruptcy
disaggregation of ROA formula
ROA = net income / avg total assets = (net income/sales) [PM] x (sales/avg total assets) [AT]
what is PM
what the company earns on each sales dollar
what is AT
sales generated from each dollar invested in assets
how can managers increase ROA
Increase PM → increase profitability for given level of assets
Increase AT → reduce assets while still generating same profit level
what impacts PM & AT
Profit margin more impacted by competitors → affect sales
Asset turnover → decisions made by managers
GPM formula
GPM = GP / sales
describe GPM
- Influenced by both the selling price of a company’s products & the cost to make or buy those products
- Generally high & increasing GPM is better
- Low or decreasing GPM signals more competition or less demand for the company’s products
- Competitive intensity has increased product line has lost appeal
- Product costs have increased
- Product mix has changed
- Volume has declined & fixed costs have not
what is operating expense margin
- Measures general operating costs for each sales dollar
- Consider each expense in whatever detail the company provides in its IS
- Compare margins over time & against peers (making sure that peers have similar business models)
general turnover
IS item / BS item
asset turnover formula
AT = sales / avg total assets
working capital turnover ratios
AR turnover
Inv’t turnover
AP turnover
AR turnover formula
sales / average A/R
inv’t turnover
COGS / avg inv’t
AP turnover
purchase or COGS / avg AP
ppe turnover formula
sales / average PPE
analysis of PPE
improving PPE turnover is not easy → it often entails:
- Divesting of productive assets or entire business lines
- Joint ventures to share assets such as distribution networks, information tech, production facilities, transportation fleets, & warehouses
- Selling production facilities w/ agreements to purchase finished goods from the facilities’ new owners
- Sale & leaseback of administrative buildings
- Lease asset → operation of business
analysis of financial leverage
- Proper use of FL benefits stockholders
- Relatively inexpensive source of capita
- Adds risk → debt repayment is mandatory
- Could be bad if it is too high → don’t have enough on hand for day-to-day operations
- Analysis of FL typically involves:
- Level of borrowed monet relative to equity capital
- Level of profit or CF relative to required debt payments
total liabilities to equity formula
total liabilities / total equity
times interest earned formula
EBIT / interest expense
what is operating focus
- ROE disaggregation w/ an operating focus recognizes → companies create value mainly through core operations
- BS & IS include both operating & non-operating items
- ROA in the traditional DuPont method, reflects a blend of the return on a company’s operating assets & its non-operating return
- Analysis can be improved if we separately identify the operating & non-operating components of the business & their separate returns
- Pretty numbers to attract more shares
ROE formula under operating focus
ROE = Operating return + Non-operating return
what is operating return in the operating focus ROE formula
- Return from operating activities
- Earned from operating assets & liabilities
what is non-operating return in the operating focus ROE formula
- Return from financing & investing activities
- Earned from non-operating assets & liabilities
what is RNOA
Return on Net Operating Assets
- Operating returns are measured by return on net operating assets
RNOA formula
RNOA = NOPAT / NOA
how do you calculate average NOA
(NOA start of yr + NOA end of yr) / 2
what parts of liabilities do we look at when analyzing ROE
borrowed money
- loans/bonds/mortgages
- interest bearing
- severe legal repercussions
operating liabilities
- AP/accurals
- interest free
- self-liquidating
The operating focus ROE treats these 2 types of liabilities differently for ROE analysis
what does self-liquidation (operating liabilities) mean?
Short-term obligations, like accounts payable, that are automatically paid off through the company’s regular business operations without requiring additional financing
NOA & formula
Net operating assets = operating assets - operating liabilities
what is under operating assets in NOA
A/R
Inventories
Prepaid expenses/supplies
PP&E & right-of-use assets
Intangible assets & goodwill
Deferred tax assets
what is under operating liabilities in NOA
Accounts payable
Accrued expenses
Unearned (deferred) revenue
Income taxes payable
Deferred tax liabilities
what’s not in operating assets in NOA and why?
- No cash in operating assets
- Certain cash is necessary for daily business (A/P)
- Pay salaries
- Most cash is more than needed to support working capital needs
- Put in short-term investments → commercial papers
why do we split operating & non-operating?
Split operating and non-operating to tell whats more sustainable
NOPAT & formula
Net Operating Profit After Tax = NOPBT - Tax on operating profit
why is equity market investment not included in OA?
…
NOPBT & formula
net operating profit before tax = sales - operating expenses = EBIT
what is & isn’t included in operating expenses for NOPBT
- COGS
- SG&A: wages, advertising, occupancy, insurance, depreciation & amortization, litigation, & restructuring expenses
- R&D
- Impairments of operating assets such as goodwill
- “Other” operating expenses or income
- Interest
tax on operating profit formula
tax on operating profit = tax expense - (pretax net operating expense * statutory tax rate) [tax shield]
describe the tax shield
- Tax shield → taxes a company saves by having tax deductible non-operating expenses, mostly interest
- Taxes saved (by tax shield) do not relate to operating profits
- Add back the tax shield to total tax expense to compute the tax on operating profit
Non-operating items on the IS include
Interest expense on debt & lease obligations
Interest & dividend income on marketable securities
Loss or income relating to discontinued operations
Debt issuance & retirement costs
Gains or losses on sale of non-strategic investments
“Other” income or expense if reported separately from operating income
Pension income or losses
what is the relationship b/w pretax non operating expense & income?
- Most companies → non-operating activities create a pre-tax net non-operating “expense”
- When reverse is true, the net non-operating item is “income”
how to compare dupont & operating focus?
dupont: ROA/ROE
operating: RNOA/ROE
ROA & FL discussion in comparing analysis
- FL relates to the degree to which the company uses borrowed money
- Important measure of the risk a company is incurring w/ its reliance on debt
- Increases risk & also increases the return to shareholders if the yield on the assets ? borrowing rate on the debt
Operating approach shows that much more of Pfizer’s ROE is due to operating activities that make up its core business as opposed to FL (operating > dupont in %)
